Inflation has external causes

SummaryIn the first part of this piece (FE, January 23), we had explained how the domestic monetary policy conduct is being increasingly influenced by external factors, as the Indian economy is being closely interlinked with its global counterpart.

but this increased to 0.33 (April 2004-December 2012) and further to 0.72 (April 2008-December 2012). Clearly, not only imported inflation, but even domestic core inflation was being driven by exogenous factors (gyrations in global commodity prices). It may be noted that RBI had started increasing rates from March 2010 onwards in an effort to control spiralling inflation.

Apart from international factors, there were also some domestic factors that were responsible for price increases, but that could not have been controlled by RBI. It is well-known that food prices have been at elevated levels for a long time, and given that retail inflation has a significantly higher weightage of food items, it is no wonder that retail prices are still ruling at more than 10%. In fact, if we look at core CPI inflation (excluding food & fuel) it has been trending downwards from June 2012 and is currently at 8.1% (overall CPI at 10.6%).

The most important reason for retail numbers being significantly higher than WPI could possibly be because of the transaction cost of food items that gets embedded in retail price through inflationary expectations. Transaction costs include transportation, intermediation, electricity for cold storages, mandi commission charges, etc. FICCI research shows that if the farm gate price for onion is R100, then the retail price could be R121.4 plus the mark-up at the retail level! Clearly, the increased retail prices over a long period of time may be attributed to a large extent on supply bottlenecks, on which the central bank may not have any control.

Also, historical trends suggest that the last time retail inflation numbers were below 5%, was in January 2006, exactly six years ago. If we assume that RBI still looks at a 5% acceptable inflation rate even for food inflation, then purely going by retail inflation numbers will not justify any rate cut any time in the near future.

Interestingly, we also used a set of statistical tools to understand the impact of an interest rate increase on output growth. We estimated Impulse Response Functions (IRFs), which are simply a set of coefficients that summarise the propagation of shocks in any of the variables across all the others over a period of time. Looking at Graph 3, the IRFs show that the rate increase impacts the output over a sufficiently longer time horizon.

RBI has been steadfast in its approach of controlling inflation over the

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